Putting a brake on high-speed trades

Friday 4 February 2011 11:08 BST

I always found Martin Wheatley a thoughtful and helpful executive when he was at the London Stock Exchange. So I think he is probably a good choice to head up that half of the Financial Services Authority which will be relaunched at some point as the Consumer Protection and Markets Authority.

The City has welcomed him, too, though largely because it was terrified that it would instead get someone from Which? magazine who would insist on the financial industry treating customers fairly and threaten it with "unhelpful" consumerist policies.

In contrast, Wheatley's background suggests he may be more understanding of the needs of the wholesale financial markets.

But it could be a classic case of not wishing for what you want in case you get it. Those in the markets applauding his appointment clearly have not been paying attention, in particular to an article he wrote last September on high-frequency trading, which is the use of computers to exploit minute differences in the prices of related products or on competing markets, and which normally exist for just fractions of a second. His analysis was easy to miss because the Financial Times published it on the inside back page of its second section, a slot its editors reserve for capital-market topics they don't really understand but think might one day be important, like Gillian Tett's repeated warnings four years ago about the risks building up in the shadow banking system.

It was important, though, because he was then still the chief executive of the Hong Kong regulator, and he really put the boot in. He said that on some estimates, high-frequency trading (HFT) now accounts for 60% to 70% of the US market and probably about half of the transactions in London, and in an era of competing exchanges they bring much-needed liquidity and tighter pricing.

But on the critical side, he noted that in terms of the basic role of a stock exchange in allocating capital to business, these traders have little value. They are not long-term holders - one US trader boasts that its average holding time is 11 seconds - they have no contribution to corporate governance, and they don't trade on fundamentals. Indeed, they neither know nor care what a company does.

Wheatley also flagged up that because the traders can execute a trade in millionths of a second, they have the ability to see large orders coming, and get in first. Some consider that this is nothing more than a sophisticated form of front-running - an activity now deemed to be market abuse when carried out by ordinary mortals.

His bigger concern, though, was that when more than half the stock exchange trades are executed in a millionth of a second by computers driven by complex algorithms, no one knows how the system might run amok.

The world did, however, have a warning on Wall Street in May with what became known as the flash crash, when shares plunged without reason in just a few seconds from more than $100 to just pennies and then just as rapidly soared back up again. It is obvious, he says, "that when a single strategy becomes as dominant as HFT appears to have become...markets become fragile. And this fragility will lead to more shock events such as the flash crash."

Wheatley then said that regulators have to do something about this, and outlined two possibilities - only one of which he liked. There could be circuit-breakers, which would slow things down in times of stress, but these would be clumsy, costly and disliked by the market.

Alternatively, and this was clearly his favoured option, there could be a new trading tax levied at a minute fraction of a penny on all HFT transactions. The point is that most HFT trades exploit microscopic price differences, and even a tiny tax would wipe out the profit margin and make a lot of HFT trading pointless and unprofitable. There would therefore be less of it because the computers would only kick in when the price anomaly was bigger than the tax charge.

So Wheatley's appointment promises to be good news for those participants who want to continue to use the stock market for its original purpose, although there is of course no guarantee that he will follow through on this taxing idea when he is in office.

It does, however, chime in with the thinking of Financial Services Authority chairman Lord Turner, who said he could not understand what possible social benefit there was in being able to trade a share in a millionth rather than a thousandth of a second.

So we can but hope. Whether this means Wheatley will be as popular in a year's time with the HFT traders and their sponsoring investment banks is a different question.